(continued from front flap) trading with ichimoku clouds …€¦ · trading with ichimoku clouds...

T R A D I N G W I T H

ICHIMOKUCLOUDS

M A N E S H P A T E L , C T A

The Essential Guide to

Ichimoku Kinko HyoTechnical Analysis

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Ichimoku Kinko Hyo is a technical system that illustrates support and resistance values in a simplifi ed form and is considered an extension of the very popular candlestick charting system. In fact, the system was built on the idea that at “one glance” you should be able to determine whether an instrument is in equilibrium (consolidation) or out of equilibrium (trending).

Written by Manesh Patel —one of the pioneering U.S. practitioners of Ichimoku trading and administrator of kumotrader.com—Trading with Ichimoku Clouds offers a detailed look at this proven approach as well as its technical strategies. Chapter by chapter, it shows you how to create and implement a trading plan based on this discipline that can easily be tailored to your trading style.

Along the way, it also takes you step by step through the entire decision-making process, from entries and exits to triggers, in order to test the trading plan created and ensure you’ve developed a successful system that fi ts your personality and circumstances.

Other topics touched upon throughout this accessible trading guide include:

• Why this approach works with all time frames and all tradable instruments

• The fi ve essential indicators associated with Ichimoku Kinko Hyo

• Which strategies can easily be adopted for stocks, futures, bonds, and other vehicles

• How Ichimoku Clouds work in both bull and bear markets

• How trading psychology infl uences trading

• How to perform post-analysis of a trading system and then optimize the system with this information

• And much more

$70.00 USA / $84.00 CAN

Filled with in-depth insights and expert advice, Trading with Ichimoku Clouds will help you implement a proven strategy designed to capture trends that maximize profi ts and minimize losses. If you’re looking to become a better trader, following some of the characteristics within this system is a step in the right direction.

MANESH PATEL, CTA, is the President of EII Capital Group, a fi nancial company that offers a variety of services, including money management, consulting, and trading. He is a technical trader whose technical foundation is

built around a Japanese trend trading system called Ichimoku Kinko Hyo. With Ichimoku Kinko Hyo, Patel trades the following instruments: currencies, futures, options, stocks, and commodities. He is actively involved in Ichimoku trading and runs www.ichimoku.net and www.kumotrader.com, which has 125,000 subscribers and is ranked 260 among active Forex Web sites. Patel is a member of the National Futures Association (NFA) and received his master’s in engineering from Georgia Institute of Technology.

Jacket Design: Michael J . Free land

Jacket Image: © Jupiter Images

( C O N T I N U E D O N B A C K F L A P )

( C O N T I N U E D F R O M F R O N T F L A P )

EAN: 9780470609934 ISBN 978-0-470-60993-4

“The ‘buy and hold’ investment strategy is a thing of the past. We are now in a ‘buy and protect’ market which means, if you are not using techni-cal analysis as a risk management tool, then you are leaving out the most important part of your investment plan. Learn this information, use it for profi t, then teach it to the world.”

—AJ Monte, CMT, Chief Market Strategist, The Market Guys

“Trading with Ichimoku Clouds is for those traders looking to learn a spe-cifi c trading style that incorporates a trading plan based on specifi c rules. This book is direct and to the point. It gives the reader an inside look into a trading system that can be applied to all markets—stocks, futures, and especially Forex. Excellent work!”

—John Person, founder, NationalFutures.com

The technical trading system called Ichimoku Kinko Hyo—Ichimoku Clouds—is seen by many as the next evolution of the candlestick method. Long a favorite in Japan, Ichimoku Clouds is now gaining an avid follow-ing in the United States and around the world. Now, Manesh Patel—one of the pioneering U.S. practitioners of Ichimoku trading and admin-istrator of ichimoku.net—offers a detailed look at this proven approach as well as its technical strategies. Chapter by chapter, Patel explains how Ichimoku trading works, and how you can create and implement a trading plan based on this discipline that can easily be tailored to your trading style.

P r a i s e f o r T R A D I N G W I T H I C H I M O K U C L O U D S PATEL

P1: JYSbind JWBT273-Patel April 10, 2010 16:24 Printer: Yet to come

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P1: JYSfm JWBT273-Patel April 15, 2010 10:15 Printer: Yet to come

Trading withIchimokuClouds

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Founded in 1807, John Wiley & Sons is the oldest independent publish-ing company in the United States. With offices in North America, Europe,Australia and Asia, Wiley is globally committed to developing and market-ing print and electronic products and services for our customers’ profes-sional and personal knowledge and understanding.

The Wiley Trading series features books by traders who have survivedthe market’s ever changing temperament and have prospered—some byreinventing systems, others by getting back to basics. Whether a novicetrader, professional or somewhere in-between, these books will providethe advice and strategies needed to prosper today and well into the future.

For a list of available titles, visit our Web site at www.WileyFinance.com.

ii

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Trading withIchimokuClouds

The Essential Guide to Ichimoku

Kinko Hyo Technical Analysis

MANESH PATEL

John Wiley & Sons, Inc.

iii


Copyright C© 2010 by E.I.I. Capital Inc. The right of Manesh Patel to be identified as the authorhas been asserted in accordance with the Copyright, Designs and Patents Act 1988.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

Charts used with permission of TradeStation, Inc.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted inany form or by any means, electronic, mechanical, photocopying, recording, scanning, orotherwise, except as permitted under Section 107 or 108 of the 1976 United States CopyrightAct, without either the prior written permission of the Publisher, or authorization throughpayment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the web atwww.copyright.com. Requests to the Publisher for permission should be addressed to thePermissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201)748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their bestefforts in preparing this book, they make no representations or warranties with respect to theaccuracy or completeness of the contents of this book and specifically disclaim any impliedwarranties of merchantability or fitness for a particular purpose. No warranty may be createdor extended by sales representatives or written sales materials. The advice and strategiescontained herein may not be suitable for your situation. You should consult with aprofessional where appropriate. Neither the publisher nor author shall be liable for any loss ofprofit or any other commercial damages, including but not limited to special, incidental,consequential, or other damages.

For general information on our other products and services or for technical support, pleasecontact our Customer Care Department within the United States at (800) 762-2974, outside theUnited States at (317) 572-3993 or fax (317) 572-4002.

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Library of Congress Cataloging-in-Publication Data:

Patel, Manesh.Trading with Ichimoku clouds : the essential guide to Ichimoku Kinko Hyo technical

analysis / Manesh Patel.p. cm. – (Wiley trading series)

Includes bibliographical references and index.ISBN 978-0-470-60993-4 (cloth)

1. Investment analysis. 2. Stocks–Prices–Charts, diagrams, etc. I. Title.HG4529.P38 2010332.63′2042–dc22

2009052168

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

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I am dedicating this book to my late father

Ramanlal K. Patel—a father who encouraged me to

be the best I can and to follow my dreams.

If it were not for him, I would not be who I am today.

A portion of the proceeds from this book will be given to various charitiesaround the world in his name.

v


vi


Contents

Introduction ix

Background ix

Components of a Trading System xv

CHAPTER 1 Ichimoku Components 1

Tenkan Sen 4

Kijun Sen 10

Chikou Span 19

Kumo Cloud Components 25

Senkou Span A 27

Senkou Span B 28

Kumo Cloud 30

CHAPTER 2 Ichimoku Trading Plan 41

Components 41

Strategy Description 42

CHAPTER 3 Ichimoku Backtesting 45

Backtesting 45

EURUSD—A Two-Year Backtest 46

Summary—Two Years of Backtesting 134

CHAPTER 4 Post-Analysis 137

Examining the Backtest Results 137

Optimize Trading Plan 144

vii


viii CONTENTS

CHAPTER 5 Ichimoku Strategies 149

Ideal Ichimoku Strategy 150

CHAPTER 6 Ichimoku Time Elements 161

Ichimoku Time Elements 161

CHAPTER 7 Applied Trader Psychology/Doug Laughlin 171

Is It as Easy as Just Being Taught a New System? 172

The Problem We Have with Getting in Our Own Way 172

Is There a Conspiracy Against the Small Trader? 173

Traders Myth—Smart People Make the Best Traders 174

Losing Trades Are Acceptable 175

A Successful System Will Fortify Your Convictions 176

Self-Sabotage and How It Applies to Your Trading 178

In Summary—Trader Psychology Overall 179

CHAPTER 8 Day Trading with Ichimoku 181

Consequences of Trading without a Trading Plan 184

Trading Plan 185

Backtesting 186

Conclusion 192

CHAPTER 9 Conclusion 193

Ichimoku Analysis Sheet 195

Bibliography 199

About the Author 201

Index 203


Introduction

BACKGROUND

“Japanese Candles” is a phrase that is well known among the trading com-munity. If the phrase is searched on the Internet, 3,810,000 searches areavailable in the Google search engine today. In comparison, if “Ichimoku”is searched, 141,000 searches appear, which is quite a difference. SteveNison brought Japanese Candlesticks to the Western world and did a greatjob illustrating how it can be used to become a successful trader. He left ahuge mark on the trading community, and today institutions down to theaverage retail trader use Japanese Candlesticks in some form or fashion intheir technical analysis.

This book brings the next phrase of Japanese technical analysis to theWestern world, “Ichimoku Kinko Hyo.” Ichimoku Kinko Hyo is a systemthat has been used successfully throughout Japan for years but never hasprogressed forward in the Western world. If a trader combines JapaneseCandles with Ichimoku Kinko Hyo, a powerful system is available to himor her. In fact, it increases the probability of trading drastically and can beevidenced by trading in a “paper” account after reading this book. JapaneseCandlesticks will not be discussed further in this book and any additionalinformation regarding this topic is available through Steve Nison’s booksand training seminars.

By the time this book is published, the market will be one that has notbeen experienced previously; not even historical traders can predict whatthe future holds. There are no historical references to the current marketmodels. We have seen the volatility index (VIX) (Figure I.1), which aver-aged a value of 10 to 12 for a number of years in the middle of this decade,and exceeded 50 for the first time during the collapse of the global financialmarkets. Why is this market different from any other historical period?

One of the biggest reasons that the market is so different is technology.With the advent of the Internet, information can be received globally in amatter of milliseconds. During the crash of 1929, no computers were avail-able and television was in its early stages. The first televised live broad-cast from a plane had just occurred. Two years earlier, the biggest news

ix


x INTRODUCTION

FIGURE I.1 TradeStation Monthly Chart of $VIX.X Volatility Index

worldwide was: “In 1927, the president of the American Telephone andTelegraph Company in New York talked by phone to Herbert Hoover inWashington, more than 200 miles away. The president of the telephonecompany was able to see clearly the face of Mr. Hoover as he talked. Thisproved to the world that electricity could be used to carry sight as well assound.”

During the mid-1980s, computers were still in their early stages. It wasthe beginning of the personal computer era—Microsoft was introducingthe operation system MS-DOS 3.2, Apple was introducing the Mac Plus,IBM was launching the first laptop computer, and so forth. Technology be-gan to advance drastically in a short period. The size of a microchip wasgetting smaller and smaller and the computing power within the microchipwas exponentially increasing in a short amount of time. What normallytook a room full of technological resources to do was now available inthe size of a desktop computer.

A perfect example of the rapid change in technology is mainframes.Back in the 1970s, IBM dominated the mainframe “space.” Mainframeswere performing the computing power needed by various industry groups.It would normally take an entire room size of more than 1,000 square feetjust to be able to store this technology. Not only that, the room neededthe ability to store all the cabling and also required the support of a


Introduction xi

high-powered cooling system. The expense associated with mainframeswas in the magnitude of more than $100,000. Only big corporations and uni-versities could afford such “luxuries.” Small companies had to perform cal-culations by hand or they had to hire some of these larger corporations toperform the task they needed. With the introduction of personal computersin the mid-1980s, small companies and private individuals were now ableto directly participate in the computer era. Prices dropped from a six-figurenumber to a magnitude of $3,000 to $5,000. My personal experience backin the 1980s was with the Apple IIE and then progressed forward with theIBM XT machines with Microsoft DOS. These were the days where therereally was no graphical interface and everything was in the form of puretext.

In the 1990s, technology introduced the concept of the Internet and theWorld Wide Web. A drastic event in a small town in India now can be heardand seen throughout the world in a matter of seconds. Information trav-eled the world in microseconds compared to days/weeks/months as it didin earlier decades. In regard to the financial markets, one event in a partic-ular market caused an instant “chain reaction” across all financial marketsglobally within a short amount of time. Not only can the events occur in-stantly but they can also affect everyone, that is, lower, middle, and upperclasses worldwide. By the late 1990s, almost every individual around theworld had some sort of investment in some financial market, either throughan online real-time brokerage account, money market account, CD, retire-ment account (401(k)), and so forth. Control was now in the hands of anemotional retail customer compared to a professional trader.

In this book, you learn the key aspects of becoming a professionaltrader. I walk you through the complete process of trading with IchimokuKinko Hyo. After you read the book, various resources are available to youto make sure that your journey into the “Ichimoku world” is successful.

Types of Trading

In order to trade, two key questions always need to be addressed:

Question 1: When and what price should we enter the trade?Question 2: When and what price should we exit a trade?

There are two analytical models—Technical Analysis and Fundamen-tal Analysis—that help the trader get the answers to these questions. Tech-nical analysis consists of looking at price and time action for a particularinstrument. Today, online brokerage accounts along with other firms of-fer a retail customer hundreds of indicators for price and time analysis.The indicators are sometimes called “studies” and they are mathematical


xii INTRODUCTION

formulas that represent price and time action in a certain way. With a cer-tain rule set, the graphical indicator tells a trader key information on whathas been happening with price over a certain time period. Examples ofsome indicators are Moving Averages, Average True Range (ATR), Stochas-tic, Pivot points, and so forth.

Hundreds of different strategies can be found with these indicators.Strategies take the various indicators and come up with a certain set ofrules that the trader can follow to trade. Infinite numbers of possible strate-gies can be created for a trading system by a trader with the hundreds ofindicators available. Furthermore, some strategies focus only on certainmarkets and on certain time frames. The days of trading based on a sim-ple strategy are gone! Technical charts are now cluttered with indicators,lines, text, graphical objects, and so forth. The charts are so cluttered thatit is hard for anyone new to understand a chart at “first glance.” It takesdays and even months for someone to understand how to trade based onsomeone’s trading system.

My background is engineering and as a result, I tend to overcompli-cate things as many engineers have a tendency to do. Before the days ofIchimoku Kinko Hyo, I mainly traded stocks. If someone looked at mycharts before I adopted Ichimoku Kinko Hyo, he or she would be com-pletely confused. In performing a technical analysis, I would first start bydrawing Fibonacci lines and Gann lines. If this revealed a possible entry, Iwould then look at the Commodity Channel Indicator (CCI), the AverageTrue Range indicator, and the stochastic indicator. If I got a “green light”from those indicators then I would look at the market indexes and see if itsupported my decision in the direction I planned to take.

I never wanted to trade against the market in general and as a result, Iwould look at the Trading Index Indicator (TRIN) and then analyze the S&Pfutures with Fibonacci/Gann/CCI/ATR, and so forth. If everything “linedup” on my two-monitor screen, then I moved forward to trade based on piv-ots. I hope that everyone followed that because I was insane back in thosedays. I look back and wonder how I understood the complicated processthat I created. That is a lot of work just to analyze one stock. You can im-age how hard it was to analyze all 5,000-plus stock instruments. One personstated it perfectly to me when they saw my screens: “death by indicators.”

Unlike technical analysis, which is graphical, the second analyticalmodel—fundamental analysis—is based on numbers. Let us first look atfundamental analysis for stocks and how it is used. In fundamental valu-ation for stocks, you are looking to buy a stock based on that company’sbeing undervalued. In order to determine if a company is being underval-ued, a “fair value” for a company needs to be determined. Some tradersmay use a Profit/Earnings (P/E) ratio to determine whether to purchase a


Introduction xiii

stock. For example, if a P/E ratio of 10 is used, then any stock at a P/E of10 or less could be purchased.

One of the key things I look at is the 10 P/E ratio level on a chart. If yousee a P/E ratio of 10, normally you see technical support in that particularstock. Other variations that may be used are stocks at a P/E level of 10or less as well as Cash to Short Term (ST) Liability’s level of 50 percent.This would indicate the stock is trading at a low earnings multiple. Thestock is well funded in terms of its debt exposure. All of this obviously hasnothing to do with technicals or charting—it’s financial company analysis.But when overlying these stocks onto a chart you may be able to applysupport levels to this fundamental analysis.

Today, if you listen to the news, you will see that many companies pro-vide many revisions to their numbers and also many companies are “cook-ing the books.” They manipulate numbers before earnings announcementsjust to drive the stock price higher. Based on these manipulated values, fun-damentalists will buy/sell the stock. If the truth comes out, their investmentwill be destroyed completely. In the last couple of years, many companieshave been getting in trouble based on “accounting practices.” How can youtrust the results if this is happening more and more often? Let us say that acompany is not manipulating the numbers and they announce a good quar-ter, why does a stock go down when they beat estimates and have goodfundamental values? Why will some instruments move more than 20 per-cent faster than their earnings percentage growth? There is no direct an-swer to these questions. Everything depends on speculation, which is notpredictable. Here is an article in USA Today on June 27, 2002, on a com-pany called WorldCom:

WorldCom’s accounting game is stunning investors who thought the

loophole the telecom firm used was sewn shut years ago.

Showing that accounting gimmicks may fade but never really

go away, WorldCom acknowledged it improperly “capitalized” costs.

This shenanigan was believed to be one that is quickly detected by

analysts and, if not, used to fudge books by much smaller amounts.

“This had been a huge problem at one time, but it has receded

over the years,” says Robert Willens of Lehman Bros. “How was this

overlooked by people who are supposed to be looking at it?” he asks.

WorldCom used the gimmick to a level never before seen. The

company showed a $1.4 billion profit in 2001, rather than a loss,

by using what’s essentially the oldest trick in the book.

Rather than subtracting certain costs—which analysts think

were for maintaining telecom systems—from profit, it called them

long-term investments. Doing this allowed WorldCom to inflate


xiv INTRODUCTION

earnings because the costs of long-term investments are subtracted

from earnings over time, rather than all at once up front.

WorldCom wouldn’t say which costs were incorrectly recorded

Things to keep in mind about improper capitalization:

High-profile companies have pulled it off before. It’s an easy way

for high-growth companies to delay recording costs, says Howard

Schilit, president of the Center for Financial Research & Analysis.

For instance, America Online paid a $3.5 million fine to the Se-

curities and Exchange Commission in 2000 to settle charges it cap-

italized the costs of mailing out thousands of trial diskettes in the

mid-’90s.

The SEC found that by not charging the expense right away, AOL

reported a profit instead of a loss for three years. AOL says it stopped

capitalizing the costs in October 1996 because it changed its busi-

ness model. “This was completely different, as AOL’s accounting was

always fully disclosed and AOL did not admit any wrongdoing in its

settlement agreement,” says spokeswoman Ann Brackbill.

Any company in any industry can use the tactic.

We have discussed fundamental analysis for stocks but are the cur-rencies the same? How do you now apply fundamental analysis to tradingcurrencies? In order to answer this question, central bank policies need tobe discussed. First, there is hawkish (which is a bias toward raising inter-est rates). A bank can do this to stop inflation, to reduce money supply,and so forth. Normally if the future of a currency has higher interest rates,then the value of that currency should increase. Next, there is a centralbank policy that is dovish (which is bias toward lowering interest rates).This policy is used to increase money supply, help stimulate an economy,and so forth. If you can find a currency pair with one country being dovishand another being hawkish then you have a great currency trade from afundamental viewpoint. For example, in the past few years, the Japaneseyen (Japan had a Zero Interest Rate Policy) versus almost any currency.If you have ever heard of the famous concept “carry trade,” it is dealingwith the Japanese yen and other currency pairs. Since the financial marketmeltdown, the United States has had a policy of keeping rates under 1 per-cent for an extended period of time. As a result, the U.S. dollar is a carrytrade with the Japanese yen and has subsequently led to a decline in theU.S. dollar.

So far, fundamental analysis for stocks and currencies has been dis-cussed and it is apparent that you have to know a lot of information inorder to trade stocks and currencies with this approach. How do the otherinstruments such as commodity futures (Corn, Wheat, Soybeans, FeederCattle, and so forth) fare with fundamental analysis? If you are trading all


Introduction xv

these instruments, you have to have a “global” view of everything that isgoing on in the world in order to trade. Some traders have taken the timeto learn, especially with the Internet; however, for many people that is vir-tually impossible.

The main goal of this book is to simplify trading. All the fundamentalaspects of each instrument and market will be built into price. Therefore,we are only going to rely on price action on the charts to determine whento trade and when not to trade. This is the assumption behind IchimokuKinko Hyo, a technical system. If you are a fundamental trader, my sugges-tion would be to combine the technical and fundamental analysis togetheras part of your trading system. Remember, your trading system has to besomething you are comfortable with and fits your “personality.” Anythingshort of that will be failure.

Now, we are going to proceed forward and start to create the founda-tion “blocks” for you to become a professional trader using the IchimokuKinko Hyo system.

COMPONENTS OF A TRADING SYSTEM

Trading and investing are very simple processes and we human be-

ings try to make it into something much more complex. Unfortu-

nately, we have a lot of biases that enter into trading decisions.

I believe people get exactly what they want out of the markets and

most people are afraid of success or failure. As a result, they tend to

resist change and continue to follow their natural biases and lose in

the markets. When you get rid of the fear, you tend to get rid of the

biases.

As for risk, most people don’t understand it, including a lot of

professionals, and what’s really interesting is that once you under-

stand risk and portfolio management, you can design a trading sys-

tem with almost any level of performance.

—Van K. Tharp

Background

People can learn a lot about life by observing nature’s creatures, obser-vations that can benefit every aspect of someone’s life. Let us examine acougar and how it hunts for prey. The cougar is one of nature’s fiercestcreatures. When hunting for prey, a cougar is strategic. If a cougar finds aherd of deer, it will wait patiently observing the entire herd looking for theweakness within the herd. The reason for this is that the cougar can only


xvi INTRODUCTION

run at top speed for short distances. Therefore, it is imperative to get asclose to its prey as possible before making a killing strike. Otherwise, theopportunity will be lost and it may be some time before the next one ap-pears. The more days that the cougar goes without food, the slower it willbe able to run, thus making it harder and harder to attack its prey.

So why are we talking about cougars?Playing the market is very much like the cougar’s hunt for prey.

Whether you are trading the Forex market, the Futures market, the Op-tions market, the Equities market, and so forth, you must have a plan be-fore entering each trade. If you do not, it will be harder and harder to findopportunities because each lost opportunity will take a toll mentally, phys-ically, and psychologically on your well-being.

Therefore, you must observe the instrument greatly before executinga trade. In another words, you must become an analyst before a trader. Ifyou are a trader before an analyst then you will be “rolling dice” at eachopportunity. Just like the cougar observes its prey for weaknesses beforebecoming a hunter, you must analyze before trading, otherwise successwill get further and further away.

An analyst observes the instrument patiently until an opportunity isseen. Once an opportunity is present, a plan is executed. The plan consistsof entry criteria, money management, and so forth. Figure I.2 is an exampleof a good trading plan. A true trader will not play a “probability game” butinstead wait for the market to “show” him or her the opportunity throughpatience and discipline.

Someone once told me “Trading is neither logical nor predictable.” Af-ter years of trading, I can honestly say that statement is completely true. It

Analysis

Find Trades

High Probability

SeasonalScansCNBC

MagazineNewspapers

Fundamental

Technical

P/EPEG

Earnings

IchimokuSystem

Set AlertsFutureTrade

Execute

NO

Trade?YES

DecisionHow?OptionFutures

Instrument

MoneyManagement

FIGURE I.2 Trading Plan Example


Introduction xvii

is a probability game. You have to have a system to help increase your prob-ability of success or you are just gambling. By rolling a dice, a person hasa probability of 50 percent on the desired outcome. Therefore, one of ourgoals is to trade with a higher probability of success than 50 percent. Howdo you do that? This can be achieved by creating a trading system that max-imizes profits when you are right and minimizes losses when you are wrong(i.e., play trends instead of consolidation patterns). A trend is when pricegoes in a certain direction for a long period of time whereas a consolidationpattern is where price goes “back and forth” among a range of prices.

Trading Plan My mentor always stated the following: “A System with-out a proper mind set leads to ruin; however, the proper mind set perfectlyaligned with the right mind set leads to Success.”

When evaluating trading systems and plans, we always ask the follow-ing two questions:

1. Does the system/plan cover the mind set required to trade the system?

2. Does the system/plan cover the personality required to trade thesystem?

Why do we ask these questions? There are many different trading plansout there. Each plan requires a particular mind set and personality fromthe trader using the system. Does your plan match your personality andmindset? If not then you are bound to fail. Take the time to find what

works for you! If the trading plan we create in this book is not for youthen change it so you are comfortable with it. Do not use it if you are notcomfortable with it.

The first component of the trading system is the trading plan. A tradingplan is where you take a certain strategy and execute it with a certain setof rules. It takes all the emotions and decision-making process completelyout so someone just has to follow the trading plan and play the odds. Themajority of retail traders today do not have a trading plan and are “blindly”trading. Without a plan, they are gambling instead of system trading. Allthey know is that they want to make money. Therefore, they go througha trial and error scenario to find a strategy that works for them. If bychance, the strategy starts to fail, they drop that strategy and seek anotherone. They switch strategies as much as the “mood” changes in the market.This is a dangerous strategy because if volatility is high then the market isswinging up and down drastically. As a result, there will be no consistencyin trading. Without consistency, traders become less patient and the lesspatient a person is, the higher the probability that a mistake will be made(i.e., higher losses). This is a vicious cycle that many cannot escape!


xviii INTRODUCTION

FIGURE I.3 TradeStation Daily Chart, Daily Chart of $INDU February 27, 2007

A perfect example of this is shown in Figure I.3. It is a chart of theDow Jones Industrial Average on May 1, 2007. On this date, the marketwent down drastically and there was a massive sell-off as people panicked.A few months later on April 18, 2007, the market had completely retraced100 percent back to the original price before the big drop. In fact, themarket continued to proceed higher. How many people do you think had atrading plan on February 27, 2007? How many people had “built-in” stops?

If you examine the price action before this major drop, you will see thatthe markets have been going higher and higher for the last couple of years.Before February 2007, the market had been in a major bull run. The priceaction set a mode of “quick easy cash” mentality. People could buy andwalk away and expect a 10 percent average yearly profit, which was threetimes more than a money market savings account. Many people thoughtit was a “sure bet” that they started to use margin to hold positions forthat quick percentage return. They did this in their regular brokerage ac-counts along with their retirement accounts. When the market decided tocorrect itself, a couple of down days caused major panic across the globe.It happened in the stock market, currency market, bond market, commod-ity market, and so forth. The big daily down bar is the panic that took place.The people who had a trading plan most likely were out before that majordown day occurred. If you were trading with Ichimoku, you would have


Introduction xix

FIGURE I.4 TradeStation Daily Ichimoku Chart, Chart of $INDU Feb 28, 2007

been out of the market either one or two days before the major down day(Figure I.4).

A trading plan should consist of the following four components:

1. What instruments will be traded and when?

a. Instrument examples: Stock, Exchange-Traded Funds, Option, Fu-ture, and so forth.

b. Time frame: Tick, 1 minute, 3 minutes, 120 minutes, daily, weekly

2. Entry Rules:

a. Fundamental: PEG, PE, Cash flow, and so forthb. Technical Analysis: Ichimoku, Moving Average, Average True

Range, Fibonacci, Gann Theory, Pivots, Volume Spread analysis,and so forth

3. Money Management:

a. Stop: If you are wrong, where will you get out of the trade? Believe itor not, there are many traders who do not use a stop at all. They arefearful that the brokers/market makers will see their stop and runthe price to hit all the stops. That is true in some cases especiallyif you are trading lower time frames. However, what will happen toyour account if a news announcement comes and moves price dras-tically in a matter of milliseconds? With the use of an automated


xx INTRODUCTION

trading system with the latest technology, millions of trades cannow be executed in less than one second! Do you want to be on theother side of the trade?

Notice, I have used the word “stop” compared to “stop loss.” Inmy mentoring, the biggest obstacle for someone to overcome is thepsychology of the word “loss” in “stop loss.” The word “loss” hasa negative meaning that people fear and try to avoid. When it doesoccur, the person’s state of mind is altered to a point where logicalthinking no longer occurs and “panic” sets in. Many people believethey do not panic when they have a loss but there are many formsof panic.

Here is a great analogy to prove the point:In elementary school, there are two boys, the first boy’s name is

Ben and the second boy’s name is Frank. Frank has a perfect atten-dance and is proud of his accomplishment and strives every day tomake sure he maintains that status. One day, Frank was walking toschool as he normally does each day. As he was walking, anotherboy named Ben approaches Frank. Ben hits Frank in the stomachfor no apparent reason and then walks away. Frank does not under-stand why Ben did that so he does not take any action. The secondday Frank walks to school and runs into Ben again. Again, Ben hitsFrank in the stomach and then walks away. The third day comesand Frank, who is afraid of getting hit, decides to take another routeto school in order to avoid Ben. Frank avoids Ben but he arrives toschool late. The route he had to take was a route that took longerthan he expected. His perfect attendance was ruined in one day dueto Ben!

So what is the moral? Frank got hit once but kept on follow-ing his plan to go to school as he normally does. When the secondtime occurred, he was cautious but not prepared because he didnot think it would happen again but it did. The third time, he re-acted but he lost his perfect attendance. He was so worried aboutBen he forgot about this perfect attendance, which was importantto him.

When trading, if you view the word “stop” as a loss, it is a neg-ative state of mind. If it occurs once, twice, three times, and so on,sooner or later it will alter your state of mind to a point where youwill start to react to it instead of following your “game plan.” If youget stopped out of a trade that means you were wrong. Remember,the goal is to have a trading strategy that minimizes losses whenyou are wrong and maximizes profits when you are right. Notice Isaid minimize not none? Using the word “none” is not real, it is adream world.


Introduction xxi

b. Profit target: Some strategies use a profit target and some don’t. Itis a not a must compared to a Stop.

c. Position sizing: As the trend develops, you have an option of addingor removing positions. One strategy is where you enter the initialposition with a low contract/share size. This is done to lower riskand to “test the field.” If the trend develops then you add more andmore positions on pullbacks. The second strategy is the reverseof the first one and you start with a large number of contracts/shares. As the trend develops, you remove positions at majorsupport/resistance values. Each position sizing strategy has itspro/cons. You can research both types further; however, remem-ber, you must select a plan that fits your personality. If you do notlike risk at all then do not do any position sizing or any scaling in(adding) as the trend develops.

d. Time Entry/Exit: Some strategies focus around time. They typicallydo this because volume is high or low during the trading time ofinterest.

e. Money Managementi. Risk per Trade: These parameters define the most risk that a

trader is willing to take per trade. If the trade is long term, therisk per trade will be higher compared to someone who is trad-ing on a short-term time frame. For example, most people whotrade daily charts for currencies have a max risk of 200 pips pertrade. They are willing to accept this value because they are ex-pecting to be in a trade for one month to four months averagingaround 400-plus pip profit. They are expecting a 2:1 profit/riskratio on the trade. So why does this matter? The reason is thatwe are trading a system and not gambling. Everything is definedin a system so you are playing the “numbers.” If you have a losson two trades and win on another trade, you know that at leastyou will break even because the one win provided 400 pips inprofit and the two losses totaled 400 pips. Together, it equalszero. Therefore, your worst-case scenario is one winning tradetakes care of two losses.

ii. Risk per Month: The risk per month should be based on the per-centage of capital you have to invest. You want to make sure thatyou do not lose all your money in one month and end up with-out any cash to trade another month. Remember, you have totreat this like a business. There will be some negative months dueto the market consolidating. During those times, your system issupposed to minimize the losses. During trend months, your sys-tem is supposed to maximize profits. Risk per month can also becalled “drawn down.”


xxii INTRODUCTION

iii. Risk/Reward Ratio: The risk/reward ratio is an important calcu-lation. It is key because we are trading a trend system. The goalof a trend system is to maximize profits when you are right andminimize losses when you are wrong. In order to achieve this,the risk/reward ratio for your system has to be less than one. No-tice, I said your system. You may have some trades that have aRisk/Reward ratio greater than one, but overall, the backtest re-sults should show your system has a risk/reward ratio less thanone. In theory, if you can optimize your system to a point whereall trades have a risk/reward of less than one, then you have agreat system. This can only happen with time as you learn moreabout the optimization part of backtesting.

4. Trade Post Analysis: Probability Factor, Risk/Reward Analysis, LossAnalysis. In a later chapter, we illustrate how to “backtest” a system.Once the system has been backtested, you can get a lot of informationfrom the backtest results. The results should show you the probabilityof winning compared to losing, average Risk/Reward per trade, and soforth. Information that should be used to determine whether the sys-tem needs to be “tweaked” or optimized. For example, if you are look-ing for a 12 percent return a year then your backtest results shouldgive an average of 12.0 percent per year. If it does not then the systemneeds to be altered in order to achieve your long-term goals. Once thesystem backtest results meet the entire trader’s requirements, the sys-tem is traded in a live environment with actual cash. Now, the resultsneed to be recorded for the live account because what has happenedin the past does not necessarily mean it will occur in the future. There-fore, post analysis of the trades has to be maintained to verify that thesystem will produce the long-term goals of your business.

Remember, a trading plan is like a business plan to a business, it is amust and the key for a business to be successful.

In this book, we learn the Ichimoku Kinko Hyo trading system. A trad-ing plan is created step by step around one Ichimoku Kinko Hyo strategy.

Technical Systems The second component for our trading systemis going to be the technical analysis component. So what is a technicalsystem? Is it Fibonacci? Is it Gann boxes? Is it Pivot Points? Fibonacci,Gann boxes, Pivot Points, and so forth, are some forms of support andresistance values. In fact, every technical system is some form of supportand resistance.

So what is support and resistance? Support is when a user is short aposition in the market (betting on the instrument going down) and price

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